Friday, September 11, 2009

Fannie Mae and Freddie Mac – closing the modelling sequence

The last post – which was incredibly difficult to write – received remarkably little comment – and almost no feedback. So I am going to close the modelling sequence early – and write a few posts about the politics of Fannie Mae and Freddie Mac as standalones. Almost all the proposals for “reform” seem to leave most of the credit risks with the government and give much benefit to Wall Street bankers. That includes the original proposals implicit when Paulson – the once King of Wall Street – put them into conservatorship. I will later expose those for the vacuous positions that they are. I want to write the politics sequence so you do not have to have closely read the modelling sequence – because I know these will appeal to different audiences.

But for now I will note that most the well-informed comment has indicated that I have underplayed the role that tax losses have played in putting Fannie and Freddie into the position they are. Certainty as to their future will enable them to write back the charges against tax assets they have taken. 18 months of profitability (which they will have) plus some certainty to the future will allow approximately 30 plus billion dollar write backs at both GSEs. That will leave the GSEs with positive net worth (and able to repay government loans) in time for the 2012 election. I will leave that to the politics sequence.

I said in the first post that I will close with a comment that was once left on my blog by “Bondinvestor”. This was the only comment I have ever censored because it stole my thunder… here it is… [with annotations in square brackets and blue colour]. I pleaded on the blog for Bondinvestor to contact me – but with not much luck. Bondinvestor summarises my arguments quite well – though I think the same applies to Fannie Mae – albeit with less force.

You should take a deeper look at FRE. it was a very well run company before the crisis - and not just on the portfolio side. [I was – well before Bondinvestor left this comment.]

Look at their credit statistics. the 90+ delinquencies are high relative to history, but far below the rest of the industry - as well as Fannie Mae. [I noted this in Part III.]

The tragedy at Freddie is that they purchased non-agency AAA MBS in an attempt to meet their housing sub-goals. [I noted in Part II that the losses came primarily from the Private Label Securities.] Their calculus was that the inherent subordination in the AAA's would protect them in a credit Armageddon. [Well we got credit Armageddon and the Private Label Securities business did cause huge losses for the GSEs.]

What is fascinating about FRE is that the jury is still out on what the actual realized losses in their non-agency book will be. The AAA private label pass throughs that the agencies bought were specially designed for them. The balances were all conforming; the pools had lower CA/FL concentration than the rest of the non-agency universe; and - most interestingly - the loans underlying the GSE's AAA's were segmented from the AAA's that were sold into the public market, though they shared the same subordinate tranches. what this means is that catastrophic losses in the Type II bonds do not necessarily imply catastrophic losses in the Type I bonds (the GSE-eligible AAA's). [Analysing this was the point of Part IX. They will incur losses – just nothing like as bad as they provided for.]

If you go look at remit reports, you'll see that the delinquencies underlying the agency-eligible bonds are much lower than the DQ's underlying the non-agency bonds. [Actually I have done so – and whilst the DQs are lower in the agency-eligible pools they are not much lower. The biggest advantage that the agency eligible pools have going for them is that they retain far more excess collateral against their delinquencies.]

Now, part of the problem is that the atrocious performance of the non-agency pools will eat up the subordinate tranches, thereby depriving the GSE-bonds of their fair share of the enhancement. [They have almost entirely done so in the series I analysed in Part IX] but, given the relative performance of the loans underlying the GSE bonds, it may not matter. [It will matter with respect to the series that I have looked at – but the excess protection in the agency-eligble pools means that the GSE losses will be under half the losses incurred by the AAA strips of the non-agency eligible pools – in many cases less than 15 percent of the normal AAA losses.]

Anyway, all this is a very long winded way of saying that the actual realized losses in Freddie's $150B portfolio of private label MBS may not approach anything like the huge mark they have taken on this book (and which destroyed their capital base in the early innings of the credit cycle). [Freddie thinks about 30 billion will reverse as described in Part IX – I think it will be less – but I am having a very sophisticated conversation with one reader who thinks it will be more – and provides modelling to prove his points… I think I could be twisted to agree with him – and will put up a technical post if we (jointly) ever get around to writing it…]

I know folks inside FRE who think that the "shadow equity" that comes back on the balance sheet as the PLS portfolio pays down is on the order of $70B. that is more than enough to retire the convertible preferred note the government took as part of the conservatorship. [I know no such folks. I worked this out on my own. But I think the shadow equity is closer to 50 billion – say 25 billion that will reverse on the private label securities and the other temporary impairment plus about 30 billion in tax losses but less the 10 billion or so more reserves I think they need to take over time on the traditional business.]

Now, none of this is to say the losses on the guaranty book won't be large. but the company discloses enough information to come up with a reasonable estimate of what they could be. You just have to look at the 06/07 vintage curves and make a judgment about how long it will take those books to season. the realized cumulative losses will most likely be somewhere between $30 and $50B. they already have a loan loss reserve of $22B. so they have some wood to chop, but it's not an egregious amount. [Well I did that modelling in Part VI. I agree with the numbers Bondinvestor comes up with – actually I think the end losses will be less.]

A much bigger issue for the company than the actual credit losses is the terms of the senior convertible preferred. If the coupon is 10% if paid in cash, and 12% if they take the PIK option. That's $5B a year after tax and it wipes out all of the normalized profits of the enterprise. it's a far more egregious rate than any of the other pieces of paper the government bought in the midst of the crisis, and it was put there by the bush admin to prevent the GSE's from organically rebuilding their capital bases. [Again I agree – the object of the conservatorship terms were to wipe Fannie and Freddie out – the takeover was political in execution. However the current income of Fannie and Freddie is way above trend – and this will not be a problem if the high revenue is sustained.]

FRE preferreds trade at 1-3 cents on the dollar. they are basically warrants on the ability of the company to one day retire the government note. with a payoff function of 100x, i think it's a speculation worth taking. [They trade higher now – but I was buying at these prices.]

In summary – working through my models I will be wrong if

(a) the running income halves

(b) the end losses are higher than I thought and

(c) the “temporary impairments” – particularly at Freddie Mac turn out to be “other than temporary”.

On those I am most insecure on the running income as I discussed in Part V – but the running income is already running far faster than I anticipated when originally buying these securities.

The GSE takeover will wind up costing government surprisingly little. I think it will wind up being profitable. The future of the GSEs is not determined by their insolvency. That I think, time will take care of. It is determined by politics.

I will do a political series later – and they will have a wider audience. Wall Street wants to carve the GSE business up for the benefit of Goldman Sachs et al. The Wall Street political lobby is very effective and the terms of the GSE conservatorship prevent the GSEs from lobbying on their own behalf – which means that unless we are careful the Wall Street lobby will get what Wall Street wants. But that is for future political debate – and the Obama administration has sensibly put off decisions as to the GSE future until next year – and ideally they will put it off until even later.

I hope I have achieved what I wanted to with this series – which is to stop the model-free GSE bashing that had become the popular line of thought of the press and the blogosphere. Later I hope to take on the vested self interest behind that GSE bashing – showing them (especially the Mortgage Bankers Association) for the egregious self-interested participants that they are.

11 comments:

Sir,Forgive me for not commenting sooner on this excellent series.I have no background in economics or investing,rather merely an interested layman.Thank you so much for the effort you put into the series.

As regards Fannie Mae, reserves, they are huge, the total 3 TUSD portfolio will have to default like the Alt-A book of business for it to be appropriate.

20 million mortgages, 4% default rate, and 50% recovery rate is 56 BUSD in credit losses. I don't think Fannie's total book will develop to be as bad as the Alt-A book. Delinquencies are now 4%, this means all must turn into defaults.

What I think is that the HAMP will lead to very large losses, for Fannie already in q2 it was 4 BUSD, and then the workouts had not really taken off yet. Any loan reworked must be booked at fair value, which is what the market pays for a loan, and it is around 45% of face value. The fair value losses could therefore be HUGE. Of course, if they are wrong Fannie will earn them back, but meanwhile they are already dead, since the draws because of this HAMP will finally "kill" them.

I also think you up until this point totally have missed, in my opinion, the most important point, and that is first, the GSE's actions since the outset of this crises in 2007, have been in total contradiction to the private lenders. If Wall Street turned left, FnF turned right.

I think this is a huge problem, because FnF have been and are GSE's under very heavy influence from the government, regulators, etc. and being a private shareholder company, in my world, continued lending in CA and FL during all of the crises, must be considered "insane" in any other light than that they are just GSE's to provide support for the market in distreesed times.

Second, the "agreement", which many say were a shot-gun "agreement", meant the Boards handed over the responsibility for FnF to the Conservator, even before legally under-capitalized. In doing so they accepted onerous terms for any support. They even will have to pay a management fee from 2010. But what most people tend to forget is that the Board did get something in return, for this support, and that is to "Conserve and preserve the assets". It might seam theoretical to some, but the assets are the mortgage portfolio, and to Conserve and preserve them, to strengthen the confidence in them, is the ONLY agreement there is. Nothing else is agreed between FnF Boards and the Conservator.

I think this is very, very important, since Paulson almost immediately said guarantee fees would be "more in line with the interests of homeowners", but how can this be in line with the "agreement"? Almost nothing is said or written in the 10-k, or 10-q of what the plans or instructions are to "Conserve and preserve the assets", but over and over again it is stated that actions taken might not be in line or/and in conflict with the "agreement". The HAMP for instance, helps homeowners that are already current, but each rework means around 50-70 TUSD i fair value losses for FnF, assuming a fair value market price of 50% and an average loan of 140 TUSD. Is this according to the "agreement", is it agreed that shareholders should make draws to rework mortgages that are still current, and in addition to that not get anything for it?

I can keep on for ages, and I only find that there are simply no one paying attention to what FnF should get in return for their support. Should FnF shareholders pay for the support, any action taken must be in line with "Conserve and preserve assets". One thing they should have done, immediately, is to lower LTV or stop totally lending in CA and FL and dramatically increase guarantee fees in theses areas. NIM must be up more than they are today, since most of the NIM, is just a write-back of previously taken write-downs, so called fair value losses on the swap portfolio.

I agree 100% the takeover was political, and designed to kill them. It would be an irony if Wall Street that caused this mess with the sub-prime and Alt-A lending beginning in 2001, now also ends up taking over the 5 TUSD portfolio, with a government guarantee still in place.

ergien brought up a question i had as well. what do we know about the quality of the loans that the post-conservatorship FNM/FRE have taken? they have been supporting the mortgage business in the US by political mandate, so is it wrong to assume they have been pushed into lowering their standards? or is this the dirty work of the FHA?

I noticed your lament about the lack of feedback. I'd like you to know that I really enjoyed the series. I am trained as software engineer. Unfortunately, I have no serious education in finance or economics. This crisis was a wake up call for me to remedy my shortcoming. Thanks to your generosity and others like you, I am learning. I particularly liked the rigor you apply to the analysis. I suspect there are other readers of your blog like myself who likes these complex technical problems but lacked the training. My ignorance in the subject matter is the reason for the lack of feedback.

By the way, my favorite blog were the ones you did on bank liquidity vs. solvency. Your view was contrary to most in the mainstream and you've shared your rigorous analysis at the darkest hour of the crisis!

It would be nice if you would label/tag these interesting analysis posts you've done on the GES's -- by clicking on the tag you'd be able to list all of them on one page. That's the way it works on other sites, anyway.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.